The Global Zeitenwende
How to Avoid a New Cold War in a Multipolar Era
In its zeal to fight inflation, the Federal Reserve has raised interest rates several times this year. America’s central bankers have focused on the usual set of statistics, growth rate, unemployment, industrial capacity. So have most market watchers. Growth is microanalyzed, almost feared. The domestic economic indicators, as they are called, have mesmerized both central banker and bond trader for so long that neither seems to have noticed just how faded the old red flags have become. They have overlooked a far larger and more important trend, a global economy that has fundamentally changed the inflation calculus.
Inflation is not a threat in the United States. Nor is it for the foreseeable future. It has been remarkably flat and will remain so, unless the Fed or the markets begin spurring inflation with higher interest rates. The Fed and most market watchers have undervalued their greatest allies, open, global, and increasingly fluid markets for goods, labor, and services. International competition will tame prices in a broad swath of the U.S. economy. The old domestic indicators, while perhaps important in gauging certain narrow trends, no longer determine the broader inflation outlook.
America’s central bankers, as well as their counterparts abroad, are running economic policy in a global era from a playbook written for a relatively closed national economy. They are fighting the inflation wars of times gone by, and the markets keep cheering them on. Vigilance against inflation is a legitimate aim, but the Fed also has a broader purpose. Its parallel goal must be to ensure the health of all money and capital markets in their depth, breadth, and liquidity. Today, that task requires a touch far subtler than the broad swipe of interest rate hikes.
The Fed must reassess the supremacy given to both its inflation fight and the use of interest rates as its primary policy tool. The risks that central bankers must balance have shifted. Inflation is far less threatening than the prospect of recession or slow growth, and raising interest rates to dampen inflation offers a cure that is often far worse than the disease. Successful reform will allow the Fed to get off the back of the U.S. economy and give America the more robust levels of growth that it deserves.
IT’S A SMALL WORLD AFTER ALL
Technological changes have created a global arena for competition among the world’s capitalist economies, multiplying the size of nearly every kind of market. International currency markets routinely exchange $1 trillion a day. Capital and commodities markets relay similarly vast sums across continents in the blink of a computer cursor. Technology now allows firms to shop in a global marketplace and to devise complex strategies integrating labor, materials, and consumers from around the world. Faced with these trends, national economic barriers have generally relented. Lower financial and trade walls are now codified in the new General Agreement on Tariffs and Trade, the North American Free Trade Agreement, the further integration of the European Union, and a host of other regional groupings and bilateral accords. The power of markets is truly remarkable when protectionist forces are kept in retreat.
The scale of the change is staggering. In Eastern Europe and Latin America new democracies and market economies are struggling to find their feet. East Asia’s miracle economies are maturing. With new dedication to the welfare of consumers rather than producers, living standards are rising dramatically. India is liberating its financial markets and trade regime, generating strong gnp growth. China is poised to become an economic power in the 21st century if centrifugal forces do not pull it apart. Meanwhile, the self-satisfied nations of the Organization of Economic Cooperation and Development are in crisis. Rising government deficits, crushing taxation, excessive regulation, and too many remaining invisible barriers to trade have sapped wealth creation. As a result, unemployment in Western Europe seems stuck at double-digit levels and is unlikely to improve much, even with an economic rebound. The welfare state, wherever found, along with its accompanying universal programs, is already an artifact of an era whose time has passed.
These dramatic changes do more than spur new economic policies. They also shape more beneficent laws to protect intellectual property, private investment, and financial transactions. The competition for capital, rather than government largess, has managed to do what no amount of prodding by foreign voices ever could. It has generated an upward spiral of economic reform in nations that had once tried, and failed, to insulate themselves from the market, often at the behest of entrenched local business interests. States now strive to create business climates that will reassure both domestic and foreign investors, while avoiding the overregulation that might stifle competition.
The competition for capital will ensure that nations continue to knock down financial and trade barriers. As long as those obstacles stay low, accelerating global competition and market integration will give consumers the luxury of choosing among a greater number of cheaper and better quality products. To meet that need, producers will exact the best buys in a global marketplace for labor and materials. This dynamic will continue as long as governments allow their citizens access to world markets in goods and services.
In a global marketplace with falling trade barriers, long-term shortages of goods and services and a scarcity of labor do not exist. The Fed errs, then, in anticipating that low U.S. unemployment of six or even five percent necessarily provides the flash point for inflation. Today, highly productive American firms can arbitrage a global labor market and draw on other supplies. Likewise, consumer demand can only spark inflation when industries cannot produce enough goods to meet that need. This may happen from time to time in a national market, but it is far less likely globally, where no one knows the limits of industrial capacity. We experience "demand pull" inflation mostly to the extent that we limit our supply of goods and services with quotas, tariffs, duties, and other nontariff barriers. That is a reality our elected officials need to learn and remember. The greatest danger to growth is the ever-present threat of protectionism.
THE INTEREST RATE ERROR
Fed policy has not caught up with the economic changes that have transformed much of the world. Macroeconomic policies that worked well in a closed domestic economy do not work nearly as well when the U.S. economy is open to global competition and financial flows. The Fed must recalibrate its policy tools and reconsider when to use them.
Central bankers are eternally confronted with the challenge of balancing the forces of growth and inflation. Too much emphasis on boosting growth increases the risk of igniting inflation; too much pressure to control inflation risks slowing growth. In resolving this dilemma, the Fed has focused on trying to control money and credit to dampen demand with interest rates and the expectation of higher interest rates. But this emphasis has largely obscured the supply side of the economic equation and the fundamental changes in the American economy that have radically altered the proper balance between growth and inflation.
The Fed’s current policy assumes that supply is essentially fixed, with domestic capacity serving as a major limit. In fact, supply can change, as it has in the American economy for some time. Globalization and the opening of the U.S. economy mean a wider pool of suppliers now compete directly for more than one-third of the goods and services purchased by American consumers. Shortages and sustained growth are now less likely to spark inflation in the same way as before. There is much less latitude for businesses to raise prices. Open markets will keep prices stable and relatively low in many economic sectors, such as semiconductors, computer equipment, autos, and electrical machinery. In areas where incipient inflation does appear, supply bottlenecks can be addressed by opening markets to foreign suppliers. If steel, lumber, or sugar prices show signs of inflating, for example, knocking out domestic price supports, taking off duties and tearing down other import barriers would deflate prices by regenerating supplies. Clearly, the surest way to tame inflation is to open markets and encourage competition.
Many service sector jobs like those in beauty parlors or restaurants remain insulated from international competition. Prices in these small businesses nevertheless depend on the costs of basic needs like energy, telecommunications, and health care. Today integrated global markets, greater competition, and technology have reduced the costs of many of those basic factors that cut across the economy and have traditionally driven broader inflation. Moreover, the mere anticipation of health care reform has already unleashed a host of competitive forces to hammer down prices. All these factors make inflation in the United States a greatly exaggerated threat.
Unnecessarily high interest rates become an invisible tax that drains middle class incomes with higher mortgage payments and credit rates. U.S. growth is slowed, unemployment is spurred, and efforts to reduce the federal deficit are set back. The Fed rate hikes instituted so far this year will cost government billions of dollars more to finance the deficit. Slower growth, meanwhile, will mean less tax revenue and more relief paid out to the unemployed.
The Fed’s emphasis on taming demand through the interest rate has increasingly caused it to battle all varieties of inflation with too blunt a tool. A good example is the jarring U.S. recession of 1982. The world was suffering from inflation sparked by steep and successive increases in the price of oil. A cartel, not market forces, drove the cost of one of the most basic, pervasive necessities sky-high. Higher interest rates only became another cost in everyone’s equation, until the pain in bankruptcies and lost jobs was so severe that spending had to slow down. Instead of stopping inflation, higher interest rates helped drive it, at an enormous cost to companies and communities alike.
Changing its calculation of which policies to use and when is a good first step toward a Fed that allows greater growth, but with contained inflation. Many of America’s Asian competitors, for example, sustain economic growth rates in excess of seven or eight percent. Granted, those economies are smaller and have begun from a lower base, but the fundamentals of the U.S. economy are sound, and they provide no indication that the U.S. economy could not manage higher growth rates, perhaps of five or six percent, driven by productivity gains.
It is more by convention or habit than reason that it has become somehow unseemly for a "mature" industrial economy to run much faster than three percent without inciting the carping of inflation vigilantes on all sides. That frame of reference for growth, called maximum sustainable capacity by economists, was largely developed in the 1950s, 1960s, and 1970s. Today, the parameters of growth are substantially expanded. The deeper integration and breadth of competition that has come to the global economy in only the past decade have opened the way to more robust growth even among the developed nations. The Fed has been cautious to a fault. It makes a tragic mistake by erring on the side of slow growth, denying Americans a more dynamic economy, diminishing living standards, and cutting off capital to emerging markets.
UPDATE THE FED
Much of the problem is that the Fed is preoccupied with old problems and old techniques. It remains far too focused on commercial banks. Today the very definition of "money" has changed, and alternatives for credit and capital have expanded substantially. Far less of both actually reside in the commercial banking system. Since the mid-1960s, commercial banks have increasingly eluded the Fed’s shorter reach. They buy money wholesale. They issue certificates of deposit and buy and sell dollars on global currency exchanges. Commercial paper, mutual funds and other sources of capital abound.
These developments have substantially reduced the Fed’s leverage. The Fed nonetheless insists on trying to regulate the total money supply and achieve its policy objective through interest rates. This approach, moreover, has never adequately accounted for the "velocity" of money, that is, the number of times dollars are used in transactions. Technology today turns money over faster through a greater multitude of transfers, sales, and purchases than ever before. The general weakness of the Fed’s approach is illustrated by its attempts to combat inflation in the early 1980s, when interest rates had to reach a staggering 20 percent before their effects could be felt.
To a large extent the soundness of the overall financial system depends on factors beyond the Fed’s control. Sound fiscal policy, of course, is key, but financial stability still relies in large measure on sound macroeconomic policies that limit the growth of the money supply and ensure price stability. Today those tasks require that the Fed take a far broader view of all financial intermediaries, brokerage houses, insurance and finance companies, and mutual and hedge funds. Concentration on commercial banks must be relinquished in favor of the broader marketplace.
The Fed must shift from attempting general monetary control exclusively through the interest rate. Instead, it must focus equally on selected monetary tools. The Fed’s aim should be to protect against extremes, excessive leverage, speculation, grossly exposed portfolios, that put the entire financial system at risk. If capital markets are too frothy, then cool them off by ratcheting up margin requirements or changing risk-based capital ratios. If bubbles are forming in real estate markets, then broaden disclosure requirements. Let the rating agencies and markets lend a helping hand. The Fed has had these and similar tools available to it for years, but it has too rarely used them. Importantly, such an approach is less likely to produce the same widely damaging effects on economic growth that eventually accompany interest rate hikes.
Other Fed reforms will require legislative changes by Congress. Consensus is widespread that radical developments in the financial services industry have outstripped an antiquated regulatory apparatus. Yet lawmakers have been virtually paralyzed over the specifics of reform. Since the late nineteenth century, Congress has sought to preserve the soundness of the financial system by separating the business of commercial banking from unrelated investment activity. While the barriers between financial institutions remain intact, the activities of various financial intermediaries have blurred. Banks are now major sellers of mutual funds and annuity deposits. Insurance companies own banks and securities firms. Telecommunication companies, automakers, and retailers issue their own credit cards.
Today proper control of these expanding services requires allowing financial and nonfinancial companies to affiliate themselves in holding companies. These holding companies would conduct various financial activities in separately capitalized subsidiaries, banking in one, securities in another, insurance in a third. The appropriate state and federal authorities would supervise and regulate the subsidiaries within their respective spheres. The Federal Reserve Board, meanwhile, should be empowered to exercise oversight of the entire system as it relates to the safety and soundness of money and capital markets.
UNLEASH THE ECONOMY
The challenge facing America today is to create enough global growth to lock in the political and economic changes that are still tentative in many parts of the world. That means providing enough capital to emerging economies so that they can generate the growth needed to absorb vast pools of unemployed. Growth alone can lift living standards and generate the disposable income needed for new consumers to enter the global marketplace for goods and services, in turn creating more jobs.
During the 1987 stock market crash, central bankers responded admirably, and immediately, to the resulting liquidity crunch by opening monetary spigots. This action nipped a financial crisis in the bud by providing global markets with the capital they required to avert an implosion and economic contraction reminiscent of 1929. America weathered the 1987 storm because monetary and government authorities recognized the true nature of the threat. The crash savaged balance sheets and shrank the world’s supply of wealth. The market endured a humdinger of a correction and within a year was again testing its all-time highs. Since then, the markets have been tested again, but this time by periodic threats of excessive speculation in foreign exchange or portfolio leverage.
The real problem we face today is not a market crash, bubble economy, or runaway inflation. Instead, we are called upon to oversee a change of epochs. The world is undergoing a historic transition from the Cold War era to something as yet undefined. The globe’s volatile mix of growth and stagnation, opportunity and danger, typify a time of transformation. As nations grope their way in this new order, with so much at stake and so much at risk, fears of a problem we do not have, inflation, threaten to choke off the lifeblood to a vulnerable world still waiting to be born.
We are presented with a historic opportunity to reshape the world for the better. Will we have the courage to challenge outdated assumptions, procedures, and tools? Will we have the vision to create new institutions like the World Trade Organization and expand our horizons in the tradition of the founders of Bretton Woods? Or will we view the world’s future simply in terms of ensuring inflation of three percent or less? Current Fed policy dooms America to a twilight existence, sending it lurching from recession to shallow recovery and back again, each time taking much of the world economy with it and precluding the United States from being the leader the world expects it to be.